Bond price behaviour in CAPM

Regarding Bond price behaviour American economist-Eugene Francis "Gene" Fama has great contribution. Some of his theories are as follows:-

First, Fama proposed three types of efficiency: (i) strong-form; (ii) semi-strong form; and (iii) weak efficiency. They are explained in the context of what informationis factored in price. In weak form efficiency the information set is just historical prices, which can be predicted from historical price trend; thus, it is impossible to profit from it. Semi-strong form requires that all public information is reflected in prices already, such as companies' announcements or annual earnings figures.We provide Homework Help 24*7 assistance by Transtutors.com.Finally, the strong-form concerns all information, including private information are incorporated in price; it states no monopolistic information can entail profits, in other words, insider trading cannot make a profit in the strong-form market efficiency world. Second, Fama demonstrated that the notion of market efficiency could not be rejected without an accompanying rejection of the model of market equilibrium (e.g. the price setting mechanism).This concept, known as the "joint hypothesis problem," has ever since vexed researchers. Market efficiency denotes how information is factored in price, Fama (1970) emphasizes that the hypothesis of market efficiency must be tested in the context of expected returns. The Joint hypothesis problem states that when a model yields a return significantly different from the actual return, one can never be certain if there exists an imperfection in the model or if the market is inefficient. Researchers can only modify their models by adding different factors to eliminate any anomalies, in hopes of fully explaining the return within the model. The anomaly, also known as alpha in the modelling test, thus functions as a signal to the model maker whether it can perfectly predicts return by the factors in the model. However, as long as there exist an alpha, neither the conclusion of flaw model nor market inefficiency can be drawn according to the Joint Hypothesis.Fama (1991) also stressed that market efficiency per se is not testable but to be tested jointly with some modelof equilibrium, i.e. an asset-pricing model.We provide Homework Help 24*7 assistance by Transtutors.com.

Reasons for bond price fluctuation:

Bonds can change in price for essentially two reasons: (1) the issuer's riskiness changes; and (2) economic changes cause interest rates to change - most pronounced for long-term bonds. Effect of changes in debt rating. What happens if a debt rating agency (such as Moody's) downgrades AT&T debt? The bonds now must offer a higher yield; to compensate for the debts now perceived higher risk -- the bond's price falls. For example, if the required return (yield) on the second listed bond increased to 8.9%, the price would fall from 97.75 to about $95.08. (The price would rise if AT&T's perceived riskiness fell.We provide Homework Help 24*7 assistance by Transtutors.com.

Effect of changes in interest rates.What happens to the price of AT&T bonds if the Federal Reserve lowers the prime lending rate and markets perceive that long-term interest rates will fall? The bonds now can offer a lower yield, in line with the market's expectation that long-term debt will pay lower interest rates, and the bond's price rises. As we have seen, when a bond's coupon rate differs from its yield, its price will differ from par value. Notice the relationship between a bond's coupon rate and the required return (yield).

Bond trades at discount: - when its coupon rate is less than the current yield (its price will be below par).

Bond trades at premium: - when its coupon rate is more than the current yield (its price will be above par).

As a bond gets closer to its maturity date, the bond's price approaches par value. That is, the shorter the time until a bond's maturity, the less responsive is the bond's price to interest rate changes. You can confirm this by looking at the attached bond pricing spread sheet. For this reason, short-term debt has less "interest rate risk" than long-term debt.

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